Article by Charles Hecht of Hecht & Stechman.
Reprinted with permission from The Financial Management Network.
Citing a study which found that over half of financial reporting frauds involved the overstating of revenue, the Securities and Exchange Commission (SEC) recently issued a Staff Accounting Bulletin (SAB) in its continuing efforts to combat earnings management. In SAB 101, the SEC provides guidance to public corporations in the recognition of revenue, income statement presentation and required disclosures concerning revenue in financial statements and SEC filings.
SAB 101 does not change any existing rules on revenue recognition contained in accounting literature, but explains how those rules are applied by the SEC Staff generally, and provides guidance as to transactions that existing rules do not address. SAB 101 states:
"If a transaction is within the scope of specific authoritative literature that provides revenue recognition guidance, that literature should be applied. However, in the absence of authoritative literature addressing a specific arrangement or a specific industry, the staff will consider the existing authoritative accounting standards as well as the broad revenue recognition criteria specified in the FASB's conceptual framework that contain basic guidelines for revenue recognition."
The basic principle followed by the SEC in its application of revenue recognition rules, which is set forth in existing accounting literature, is that revenue should not be recognized until it is realized or realizable and earned. The SEC has taken the position that revenue generally is realized or realizable and earned when all of the following criteria are met:
- persuasive evidence of an arrangement exists
- delivery has occurred or services have been rendered
- the seller's price to the buyer is fixed or determinable, and
- collectibility is reasonably assured.
SAB 101 goes on to examine each one of these criteria and applies them in a question and answer format to transactions which are not addressed in existing accounting literature such as service revenue, revenue from certain internet sales, non-refundable fees, certain pre-paid services and revenue earned on layaway sales.
The accounting and disclosure rules set forth in SAB 101 are applicable after December 15, 1999 and are also applicable retroactively. However, a registrant need not restate its previously issued financial statements if the registrant reports a change in accounting principle in accordance with APB Opinion No. 20, Accounting Changes, no later than the first fiscal quarter of the fiscal year beginning after December 15, 1999. In a subsequent release on March 24, 2000, the SEC delayed implementation for registrants with fiscal years beginning between December 16, 1999 and March 15, 2000 may report a change in accounting principle no later than their second fiscal quarter of the fiscal year beginning after December 15, 1999. With SAB 101, the SEC has sent a clear message that each registrant should review its revenue recognition and disclosure policies to ensure that these policies conform to GAAP. In addition, SAB 101 is sure to provide plaintiffs with additional ammunition to prove securities fraud under Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder. In fact, motions to dismiss securities fraud actions based on improper revenue recognition have been defeated in two recent decisions, In Re System Software Assoc., Inc. Sec. Litig., No. 97 Civ. 177, 2000 U.S. Dist. LEXIS 3071 (N.D. Ill. March 8, 2000)(Pallmeyer, J.) and Gelfer v. Pegasystems, No. 98 Civ. 12527, Fed. Sec. L. Rep. (CCH) *90,749 (D.Mass. Jan. 24, 2000)(Tauro, J.). In each action, company officers were named as defendants, including the Chief Financial Officer of the defendant corporation in Gelfer. For more information concerning the SEC's revenue recognition policies and rules, please contact Hecht & Steckman, P.C. by mail at 60 East 42nd Street, Suite 5101, New York, New York 10165-5101, by telephone at 212-490-3232 or by e-mail at [email protected] Please visit the Hecht & Steckman, P.C. website at www.securitiescounselors.com. Hecht & Steckman, P.C. is a boutique law firm specializing in securities and corporate law and litigation.